Practical Accounting 1 When the cost to retail ratio is computed after net markups (markups less markup cancellations)

have been added, the retail inventory method approximates lower of cost or market. This is
Estimating Inventories known as the conventional retail inventory method. If both net markups and net markdowns are
included before the cost to retail ratio is computed, the retail inventory method approximates
Gross profit method cost.
The gross profit method should never be used as a substitute for a yearly physical inventory unless
the inventory has been destroyed. The retail inventory method becomes more complicated when such items as freight-in, purchase
returns and allowances, and purchase discounts are involved. In essence, the treatment of the
The gross profit method is based on the assumptions that (a) the beginning inventory plus items affecting the cost column of the retail inventory approach follows the computation of cost
purchases equal total goods to be accounted for; (b) goods not sold must be on hand; and (c) if of goods available for sale. Freight costs are treated as a part of the purchase cost; purchase
sales, reduced to cost, are deducted from the sum of the opening inventory plus purchases, the returns and allowances are ordinarily considered both a reduction of the price at both cost and
result is the ending inventory. retail; and purchase discounts usually are considered as a reduction of the cost of purchases.

In developing a reliable gross profit percentage, reference is made to past years and Other items that require careful consideration
adjustments are made for current circumstances. i. Transfers-in from another departments should be reported in the same way as
purchases from an outside enterprise.
Retail method ii. Normal shortages should reduce the retail column because these goods are no
longer available for sale.
The retail inventory method is an inventory estimation technique based upon an observable iii. Abnormal shortages should be deducted from both the cost and retail columns and
pattern between cost and sales price that exists in most retail concerns. This method requires that reported as a special inventory amount or as a loss.
a record be kept of (a) the total cost and retail of goods purchased, (b) the total cost and retail iv. Employee discounts should be deducted from the retail column in the same way as
value of the goods available for sale, and (c) the sales for the period. sales.

Basically, the retail method requires the computation of the cost-to-retail ratio of inventory The retail inventory method is widely used (a) to permit the computation of net income without a
available for sale. This ratio is computed by dividing the cost of the goods available for sale by physical count of inventory, (b) as a control measure in determining inventory shortages, (c) in
the retail value (selling price) of goods available for sale. Once the ratio is determined, total sales regulating quantities of inventory on hand, and (d) for insurance information.
for the period are deducted from the retail value of inventory available for sale. The resulting
amount represents ending inventory priced at retail. When this amount is multiplied by the cost Average Cost Approach
to retail ratio, an approximation of the cost of ending inventory results. Use of this method Under the average approach, it includes both net markup and the net markdown in the
eliminates the need for a physical count of inventory each time an income statement is computation of cost ratio. It rationalizes that the inventory should approximate or equal to
prepared. However, physical counts are made at least yearly to determine the accuracy of the historical cost.
records and to avoid overstatements due to theft, loss, and breakage.
To obtain the appropriate inventory figures under the retail inventory method, proper treatment FIFO Approach
must be given to markups, markup cancellations, markdowns, and markdown cancellations. The FIFO approach is similar to the average cost approach that it considers both the net markup
and net markdown but it excludes the beginning inventory in the computation of cost ratio. It
Conventional Retail Inventory Method rationalizes that the markup and markdown will apply to the goods purchased during the year
but not the beginning inventory.

Illustrative Cases
1. On May 6, 2016 a flash flood caused damage to the merchandise stored in the warehouse 2. The Bayambang Corporation was organized on January 1, 2015. On December 31, 2016,
of Cabanatuan Co. You were asked to submit an estimate of the merchandise destroyed in the corporation lost most of its inventory in a warehouse fire just before the year-end count
the warehouse. The following data were established: of inventory was to take place. Data from the records disclosed the following:
a. Net sales for 2015 were P800,000, matched against cost of P560,000.
b. Merchandise inventory, Jan. 1, 2016 was P200,000, 90% of which was in the warehouse 2015 2016
and 10% in downtown showrooms. Beginning inventory,
c. For Jan. 1, 2016 to date of flood, you ascertained invoice value of purchases (all stored January 1 P 0 P1,020,000
in the warehouse), P100,000; freight inward, P4,000; purchases returned, P6,000. Purchases 4,300,000 3,460,000
d. Cost of merchandise transferred from the warehouse to show-rooms was P8,000, and Purchases returns and
net sales from January 1 to May 6, 2016(all warehouse stock) were P320,000. allowances 230,600 323,000
Sales 3,940,000 4,180,000
Assuming gross profit rate in 2016 to be the same as in the previous year, the estimated Sales returns and
merchandise destroyed by the flood was allowances 80,000 100,000
 On January 1, 2016, the Corporation’s pricing policy was changed so that the gross profit Freight in 400,000
rate would be three percentage points higher than the one earned in 2015. Salvaged Purchase returns 600,000 1,000,000
undamaged merchandise was marked to sell at P120,000 while damaged merchandise was Purchase allowances 300,000
marked to sell at P80,000 had an estimated realizable value of P18,000. How much is the Departmental transfer in 400,000 600,000
inventory loss due to fire? Net markups 600,000
Net markdowns 2,000,000
3. Luna Manufacturing began operations 5 years ago. On August 13, 2016, a fire broke out in Sales 24,700,000
the warehouse destroying all inventory and many accounting records relating to the Sales returns 350,000
inventory. The information available is presented below. All sales and purchases are on Sales discounts 200,000
account. Employee discounts 600,000
January 1, 2016 August 13, 2016 Loss from breakage 50,000
Inventory P143,850
Accounts Receivable 130,590 P128,890 5. The estimated cost of inventory at the end of the current year using the conventional (lower
Accounts Payable 88,140 122,850 of cost or market) retail inventory method is
Collections on accounts rec., Jan. 1- Aug. 13 753,800
Payments to suppliers, Jan. 1- Aug. 13 487,500 6. The estimated cost of inventory at the end of the current year using the average retail
Goods out on consignment at Aug. 13, at cost 52,900 inventory method is

Summary on previous years’ sales: 7. The estimated cost of inventory at the end of the current year using the FIFO retail inventory
method is
2013 2014 2015
Sales P626,000 P705,000 P680,000 8. The records of Binmaley’s Department Store report the following data for the month of
Gross Profit 187,800 183,300 231,200 January:
GPR 30% 26% 34%
Beginning inventory at cost 440,000
Determine the inventory loss suffered as a result of the fire. Beginning inventory at sales price 800,000
Purchases at cost 4,500,000
4. The work-in-process inventory of Burp Company were completely destroyed by fire on June Initial markup on purchases 2,900,000
1, 2016. You were able to establish physical inventory figures as follows: Purchase returns at cost 240,000
Purchase returns at sales price 350,000
January 1, 2016 June 1, 2016 Freight on purchases 100,000
Raw materials P 60,000 P120,000 Additional mark up 250,000
Work-in-process 200,000 - Mark up cancellations 100,000
Finished goods 280,000 240,000 Mark down 600,000
Mark down cancellations 100,000
Sales from January 1 to May 31, were P546,750. Purchases of raw materials were P200,000
and freight on purchases, P30,000. Direct labor during the period was P160,000. It was Net sales P6,500,000
agreed with insurance adjusters that an average gross profit rate of 35% based on cost be Sales allowance 100,000
used and that direct labor cost was 160% of factory overhead. Sales returns 500,000
Employee discounts 200,000
The work in process inventory destroyed by fire is… Theft and other losses 100,000

Using the average retail inventory method, Binmaley’s ending inventory is

Pugo uses the retail inventory method. The following information is available for the current year:

Cost Retail --end of Inventory Estimation--